1.

List the government safety nets that are in place to prevent a financial crisis, and the
disadvantages of government safety nets. (10 marks)

soln

1. CDIC – deposit insurance and handling of a bank failure

– Before deposit insurance, depositors would have to wait until the bank was liquidated
– Unable to asset quality of bank assets, depositors would withdrawal money even from
good banks
– This is described as a bank run
Methods to handle a failed bank
– Payoff Method
– Purchase and assumption method (2 marks)

2. The central bank can provide support to troubled institutions by acting as a lender of last resort
(1 marks)

3. The government can provide direct financial support to troubled institutions

The Canada Mortgage and Housing Corporation did this
The U.S. Treasury (and others) did this as well
(1 marks)

4. Governments can also take over (nationalize) troubled institutions and guarantee all creditors’
loans will be paid in full (1 marks)
DISADVANTAGES:
A government safety net can be a mixed blessing
• Moral Hazard
– Depositors do not impose discipline of marketplace
– Financial institutions have an incentive to take on greater risk
• Adverse Selection
– Risk-lovers find banking attractive
– Depositors have little reason to monitor financial institutions
(3 marks)

• Regulators are reluctant to close down large financial institutions and impose loses on their creditors
because doing so might precipitate a financial crisis

– Support is therefore given to institutions, even if they are not entitled to it but merely because
they are “too big”

• Increases moral hazard problems at big banks

– Once large depositors and creditors know that a bank is too big to fail, they have no incentive to
monitor the bank

(2 marks)
3. Use an appropriate graph to show the profits and losses for the buyer of a call option and the writer,
when the price of the future and the exercise price of the option is 115 and the premium is equal to
$2000.

For the graph below, X is 115, alpha is 2000

(5 for graph)

- If at the expiration date, the price of the underlying asset, S, is less than X,
the call will not be exercised, resulting in a loss of the premium
- At a price above X, the call will be exercised
- At a price between X and X + α, the gain would be insufficient to cover the
cost of the premium
- At a price above X + α, the call will yield a net profit
- At a price above X + α, each $1 rise in the price of the asset will cause the
profit of the call option to increase by $1
(1 point each, total of 5 marks)
4. Explain how Greece, Portugal, Italy and Ireland got into sovereign debt crisis. Include in your
argument outline some of the data from these countries that acted as warning signs, and ways in
which these countries have reduced the these problems. (10 marks)

- Upon entering the Eurozone in 2000, Greece and Italy had debt/GDP ratios above 100% (
1 marks)
- Portugal and Ireland reached ratios close to 100% around 2009/2010; all above the 60%
Eurozone limit ( 1 marks)
- All 4 countries had deficit/gdp ratios above the Eurozone limit of 3% in starting in
2007/2008 ( 2 marks)
- Dramatic increases of credit expansion to the private sector from banks and other
financial institutions from 2002-2007; predatory lending (1 marks)
- Dramatic increases of current account deficits over 2002-2007, reflecting heaving
government borrowing from foreigners. For the most part, a large percentage of this
borrowing went to expanding the government sector and raising wages of the public
sector employees. ( 1 marks)
- this countries and their banks engaged in excessive borrowing and lending due to moral hazard, that
being the “Euro was too big to fail”. The excessive lending, in light of moral hazard, was not checked or
controlled by proper regulation. (1 marks)

Ways in which they have reduced: reduce govt spending, increase taxation, which reduces the govt
deficit and trade account (1 marks); reform their institutions, including pension systems and competition
policies; banks have reduced lending and have engaged in increase capital ratios, (1 mark) ; banks have
reduced non performing loans on balance sheets (1 mark)